2849: Tax Basis For Beginners by Sean Mullaney of FI Tax Guy on Double Taxation & Clarifies Taxable Gains

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[00:01:05] [SPEAKER_00]: This is Optimal Finance Daily, Tax Basis for Beginners by Sean Mulaney of PHYTaxGuy.com.

[00:01:15] [SPEAKER_00]: And I'm your host and personal finance enthusiast, Diania Merriam.

[00:01:19] [SPEAKER_00]: We're going to jump right into our next post as we optimize your life.

[00:01:27] [SPEAKER_00]: Tax Basis for Beginners by Sean Mulaney of PHYTaxGuy.com.

[00:01:34] [SPEAKER_00]: What is tax basis?

[00:01:37] [SPEAKER_00]: To answer that question, let me posit two hypotheticals.

[00:01:42] [SPEAKER_00]: Hypothetical one. Mark buys one share of Acme Industries stock for $100 on Monday.

[00:01:49] [SPEAKER_00]: The following Monday, he sells that share for $100.

[00:01:54] [SPEAKER_00]: Hypothetical two. Judy buys one share of Acme Industries for $20 on Monday.

[00:02:02] [SPEAKER_00]: On Thursday, Acme Industries announces the release of a new bottle that dispenses both ketchup and mustard and the stock sores.

[00:02:12] [SPEAKER_00]: On the following Monday, Judy sells her share of Acme Industries for $100.

[00:02:18] [SPEAKER_00]: What tax results?

[00:02:19] [SPEAKER_00]: Do both Mark and Judy have $100 of taxable income?

[00:02:25] [SPEAKER_00]: Of course not.

[00:02:26] [SPEAKER_00]: We know that Mark has no taxable income, and Judy has $80 of taxable income.

[00:02:33] [SPEAKER_00]: But how do we know that?

[00:02:34] [SPEAKER_00]: The answer? Basis.

[00:02:37] [SPEAKER_00]: Basis is the tax concept that ensures amounts are not taxed twice when they shouldn't be.

[00:02:44] [SPEAKER_00]: In Mark's case, he has no real income when he sells the stock.

[00:02:48] [SPEAKER_00]: Judy, however, does have income.

[00:02:52] [SPEAKER_00]: When she sells the Cromerica stock, she realizes the $80 gain.

[00:02:58] [SPEAKER_00]: Basis is what allows us to measure the appropriate gain or income to the seller of property.

[00:03:05] [SPEAKER_00]: While we have a sense that Mark should not have had taxable income and Judy should have,

[00:03:10] [SPEAKER_00]: without basis, we have no way of measuring whether a disposition of property should trigger a taxable gain, loss, or nothing.

[00:03:21] [SPEAKER_00]: Generally, the basis of an asset is its historical cost, plus any capital improvements or additions made to the asset.

[00:03:31] [SPEAKER_00]: In the case of a financial asset in a taxable account, basis is simply the purchase price, plus reinvested distributions, less any non-dividend distributions or returns of capital.

[00:03:46] [SPEAKER_00]: Depreciation.

[00:03:47] [SPEAKER_00]: Basis serves another function.

[00:03:51] [SPEAKER_00]: Business assets are usually subject to a depreciation allowance on the theory that assets waste away from wear and tear over a useful life.

[00:04:00] [SPEAKER_00]: The method and time period for depreciating an asset varies based on the asset.

[00:04:06] [SPEAKER_00]: Residential real estate is depreciated in a straight line over 27.5 years.

[00:04:13] [SPEAKER_00]: Most non-real estate property is depreciated using an accelerated method and over a shorter period.

[00:04:21] [SPEAKER_00]: One business asset that never depreciates is land, on the theory that land has an indefinite useful life.

[00:04:28] [SPEAKER_00]: Each asset is depreciated based on its depreciable basis, which is generally historic costs plus capital improvements.

[00:04:39] [SPEAKER_00]: For example, if you purchase a fourth floor residential condo for a million dollars and rent it out,

[00:04:47] [SPEAKER_00]: each full year it's used in the rental business, you divide the million dollars depreciable basis over 27.5 to come up with a depreciation deduction

[00:04:58] [SPEAKER_00]: of $36,364 which lowers the taxable income from the rental activity and may even be currently deductible against other income if the rental property produces a loss.

[00:05:13] [SPEAKER_00]: Note that some of the basis may be attributable to land, which is good basis that can be recovered upon a sale but it can't be depreciated.

[00:05:23] [SPEAKER_00]: Step up at death.

[00:05:25] [SPEAKER_00]: The tax code offers a tremendous benefit for those looking to facilitate second generation FI.

[00:05:33] [SPEAKER_00]: The tax basis of inherited assets is stepped up to their fair market value of the asset on the original owner's date of death.

[00:05:42] [SPEAKER_00]: This means, among other things, it's usually much better to leave an asset to an heir at death rather than to gift that asset to an heir during life.

[00:05:52] [SPEAKER_00]: The asset left upon death has a stepped up asset basis, while the gifted asset only has the original owner's basis in the hands of the recipient.

[00:06:03] [SPEAKER_00]: I previously wrote an example of how this works with this example.

[00:06:08] [SPEAKER_00]: William lives in a house he purchased in 1970 for $50,000.

[00:06:13] [SPEAKER_00]: In 2019, the house was worth $950,000.

[00:06:18] [SPEAKER_00]: If William gifts the house to his son, Alan in 2019, Alan's basis in the house is $50,000.

[00:06:26] [SPEAKER_00]: However, if William leaves the house to Alan at William's death, Alan's basis in the house will be the fair market value of the house at William's death.

[00:06:36] [SPEAKER_00]: Lastly, in order to qualify for the step up at death, an asset must be held in a taxable account.

[00:06:43] [SPEAKER_00]: Assets held in retirement accounts don't receive a step up at death.

[00:06:51] [SPEAKER_00]: Basis is what makes tax loss harvesting possible.

[00:06:56] [SPEAKER_00]: Picture Joey, who owns Blue Company stock worth $10,000.

[00:07:01] [SPEAKER_00]: He purchased the stock a year ago for $13,000.

[00:07:04] [SPEAKER_00]: He can sell his Blue Company stock and deduct the $3,000 loss on his tax return, realizing a nice benefit.

[00:07:13] [SPEAKER_00]: Tax loss harvesting is a neat tool in the tax planning toolbox, but it's a fool's errand to succumb to the tyranny of tactics and arrange one's portfolio around tax loss harvesting.

[00:07:26] [SPEAKER_00]: At most, tax loss harvesting reduces your taxable income in any particular year by $3,000.

[00:07:34] [SPEAKER_00]: Over the long run, that's not the way to build wealth and achieve financial freedom.

[00:07:39] [SPEAKER_00]: Sure, play the tax loss harvesting card when the right opportunity arises, but don't structure your portfolio with dozens of holdings in the hopes you can get a $3,000 loss every year.

[00:07:51] [SPEAKER_00]: Rather, structure your portfolio with your ultimate goal in mind.

[00:07:56] [SPEAKER_00]: And if towards year end an opportunity to do some tax loss harvesting arises, pounce on it.

[00:08:03] [SPEAKER_00]: Retirement accounts

[00:08:04] [SPEAKER_00]: The term basis means something a bit different in the context of retirement accounts.

[00:08:11] [SPEAKER_00]: Two points.

[00:08:12] [SPEAKER_00]: First, it's possible to have basis in a traditional account.

[00:08:15] [SPEAKER_00]: Generally, this means that non-deductible or after tax contributions have been made to the account.

[00:08:23] [SPEAKER_00]: And thus in the future, when there are taxable distributions, a portion of the distribution will be offset by that basis.

[00:08:31] [SPEAKER_00]: Second, the assets inside of a retirement account, including a Roth account, do not have basis to the owner of the account.

[00:08:39] [SPEAKER_00]: These assets do have basis, but that basis is never directly accessible to the owner of the account, in the way that depreciable basis or stock basis is accessible to the owner.

[00:08:52] [SPEAKER_00]: Importantly, assets inside of a retirement account do not enjoy this step-up in basis at the owner's death that assets in a taxable account enjoy.

[00:09:05] [SPEAKER_00]: You just listened to the post titled Tax Basis for Beginners by Sean Malaney of 5taxguide.com.

[00:09:12] [SPEAKER_00]: And I'll be right back with my commentary.

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[00:10:17] [SPEAKER_00]: Something I learned recently is how Basis relates to drawing down on an investment portfolio.

[00:10:23] [SPEAKER_00]: I'm a long way off from touching my portfolio, but it's good to know that there are additional considerations for managing my tax burden when the time comes.

[00:10:33] [SPEAKER_00]: There are three different methods to determining basis when you sell stocks.

[00:10:38] [SPEAKER_00]: FIFO or first in, first out.

[00:10:41] [SPEAKER_00]: LIFO or last in, first out and specific identification.

[00:10:47] [SPEAKER_00]: This matters because as a long term investor, I'm invested in the same funds at different times and at varying prices.

[00:10:55] [SPEAKER_00]: When I decide to sell some shares, I can choose to sell the shares with the highest cost basis to minimize taxable gains.

[00:11:04] [SPEAKER_00]: Conversely, I can choose the shares with the lowest cost basis to maximize realized gains if I want to offset other losses.

[00:11:13] [SPEAKER_00]: For example, consider an investor who wants to sell 50 shares, but they have 200 which they purchased at different times and prices.

[00:11:21] [SPEAKER_00]: They have 100 shares that they bought for $50 each and another 100 shares at $100 each.

[00:11:27] [SPEAKER_00]: Using FIFO, the basis of the first 50 shares sold would be $50 each, resulting in a lower basis and potentially higher taxable gain if the current price is above $50.

[00:11:41] [SPEAKER_00]: Using LIFO, the basis would be $100 each, leading to a higher basis and potentially lower taxable gain or a higher tax deductible loss.

[00:11:52] [SPEAKER_00]: Specific identification offers the most flexibility, allowing the investor to select the shares with the most favorable tax implications.

[00:12:02] [SPEAKER_00]: The important part of all of this is having detailed records which any reputable brokerage should be able to provide.

[00:12:09] [SPEAKER_00]: And that'll do it for today. Have a great day and weekend, and I'll be back here tomorrow where your optimal life awaits.